Trading robots are not evil, says professor

High-frequency trading (HFT) is a good development for capital markets says Alex Frino, a professor of finance at Sydney University and chief executive of the Capital Markets Co-operative Research Centre.

He argues that HFT – where computers trade automatically at lightening fast speeds – is not the wicked tool that some think it is, finding it boosts liquidity and smooths volatility, contrary to popular myths.

Frino, who is part of a newly-formed $24 million inter-university research network called the Centre for International Finance and Regulation, has overseen research that suggests HFT actually provides greater transparent price discovery, more liquidity to markets, and reduces price volatility. His task at the CIFR is to further prove his research.

Frino has already closely studied HFT at the CMCRC, examining the role that HFT plays and its impact on market efficiency in Australia. He is prepared to defend the robotic trading cause – and to do this, he has obtained a $2 million grant from the CIFR for further research into high-frequency and algorithmic trading.

His CIFR project will focus on the most important developments in global capital markets, one of those being HFT, and the impact of HFT on market integrity and market efficiency.

The further study is part of the CIFR’s mission to put Australia at the forefront of global financial developments. The CIFR’s focus is financial markets research, regulatory responses and enquiry into regulation and risk management.

As HFT takes the financial markets by storm and changes the way exchanges do business, it has become necessary for brokers to become increasingly sophisticated in their execution methods.

“Gone are the days when one of the KPIs of a [trading] desk is how quickly they answer the phone," Frino says, noting that the buy-side is demanding more in terms of lowering and managing transaction “T" costs.

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The major focus of Frino’s research is liquidity and volatility. The further study – which will draw on data from fund managers – seeks to progress existing theories about the effects of HFT on the marketplace.

“Unfortunately the period in which HFT grew enormously in Australia also coincided with the GFC [global financial crisis] and huge volatility and slippage, so disentangling the two is really important to reaching a conclusion," Frino says.

“All the best measures of market liquidity that we’ve looked at suggest that liquidity has improved and therefore you’d immediately conclude that T costs have declined. We just really want to nail it down and that is the second piece of research that we are doing."

Frino’s existing research challenges some of the myths floating around the market, which he says, predominantly appear to have come from buy-side of the market.

One of the myths is that HFTs don’t provide any real liquidity to the market place.

“A particularly important fund manager said to me that the liquidity HFTs provide to the market is like fog – he said you can see it and when you reach out to grab it your hands go straight through it," Frino says.

The point the fund manager is trying to make is that although HFTs add depth, at critical points in the market place when you want to trade, it is not there.

“That is just simply not true," Frino says.

Frino has used data from the ASX to analyse whether HFT traders make or take liquidity in the market.

“We looked at the make to take ratio and found that they are net providers, makers, of liquidity. I think that is just a stunning indictment of this myth," he says, noting that “fear of the unknown" fuels the myth.

Some in the market harbour concerns about HFT and the industry’s secretive nature doesn’t help it.

HFT makes up about 30 to 50 per cent of the Australian equity trading market, Frino says, while in the United States it makes up about 70 per cent. It is difficult to get more precise numbers as HFT volumes are not published.

“I think the most stunning chart is the average trade size – we know HFTs trade small quantities and turn it over very frequently," Frino says. “In aggregate they trade quite a lot in that way. If you look at the average trade size in the last three years it has dropped from something like 40,000 shares per trade down to about 10,000 shares per trade."

The trend indicates the growth in HFT, Frino says.

“When we marry that chart, which the market has been looking at, against actual data we have got from the marketplace, it mirrors the growth in HFT trading in Australia."

Trading data is sword that Frino mainly uses to slay HFT myths.

Another myth is that HFTs exacerbate volatility – that HFTs momentum trade, that is, they jump in front of an order, push up the price, and then sell into it.

“We’ve done some very simple correlation analysis looking at when HFTs are more present in the market place and the volatility, and rather than there being a positive relationship between the two we find the opposite, a negative relationship no matter how you measure it," Frino says.

“I think that’s indicative of the fact that HFTs probably have a stabilising influence on the marketplace – if the price runs too high they know that it is going to mean revert, it is going to come back, that is when you trade against it. Some of their trading causes that mean reversion, so I think our broad brush analysis tells us that they appear to have a stabilising impact on prices."

His conclusion contrasts with theories of others in the market who suggest HFTs caused last May’s flash crash and de-stabilise prices generally. For example, the Bank of England’s head of financial stability, Andy Haldane, recently commented in a speech to the International Economic Association in Beijing that the goal of zero latency – where trading converges at the speed of light – de-stabilises markets and needs to be reined in.

Frino says: “I think the flash crash was a peculiar set of circumstances that HFTs didn’t cause and that’s a function of the nature of the US market place. If you want to trade Microsoft in the US, there are 70 different access points to that trade. I think that’s a fundamental problem. The Americans have really tried to glue together those markets but they are so complex and the rules are so un-harmonious that was a root cause of the so-called flash crash."

As Australia prepares for multi-markets with the introduction of rival exchange operator Chi-X, Frino does not expect local conditions to mirror the US situation.

“As long as we don’t get to the ridiculous situation of having 70 access points to a stock, we won’t see the same problems," Frino says. “I think there will be good glue in our market place. I see a collection of liquidity being added to the market place. As long as there is interconnection between the market places, I don’t see any problems."

“I think if we look at one of the most stark watershed events in Australia, the shift from floor to screen-trading, the increase in liquidity overnight was phenomenal," he says. “I think that the gradual increases in liquidity from technology enhancements in the market place will also add to liquidity significantly."

While Frino does recognise that speed has its dangers, such as whether clearing and settlement systems can handle the rapid trading pace of HFT and algos, he says they can be managed.

“The market is well aware of that danger and the capital requirements hoisted on HFTs that want access to the marketplace more than compensate for that danger," Frino says.